by David Robertson, CFA
November 2014
A few years ago I took my car in to have some work done by the local car guy. When I picked it up, I noticed a warning light on the dash and asked about it. He said, in his matter-of-fact way, "No problem, I'll just put a piece of tape over it." Well this is the same guy who suggested I just turn the radio up when I asked about a squeaking sound the car was making. At any rate, after we stopped chuckling at the obvious joke, he told me what the problem was and took care of it.
If only it were so in today's capital markets. Unfortunately volatility, which typically serves as a useful warning light for market risks, has been "taped over". Certainly this makes it much more difficult for savvy investors to gauge market risks because it deprives them of a useful source of information and forces them to rely on other indicators that typically aren't as accurate. But at least they see the tape and know to look elsewhere for signals. Novice investors, however, are seriously challenged to even notice the tape and are therefore much more likely to misinterpret the situation. For them, the fact that there is no glowing warning light mistakenly sends an "all clear" signal to increase exposure to the market.
Market veteran Gary Shilling describes the situation as well as anyone in his November Insight letter: "The Fed’s bailout of Wall Street and its virtual promise to keep pumping out money through quantitative easing not only hyped stocks but collapsed risk and volatility. The broad spectrum stocks advanced pretty much in unison and stock market dispersion—the differences of individual stock performance compared to others—fell sharply, even below the pre-crisis level." In other words, an important consequence of the Fed's quantitative easing (QE) policy was to put tape over the volatility warning light.
Shilling is not alone in this assessment. Mohamed El-Erian, the well-respected former co-CEO of PIMCO and former head of the Harvard endowment offered his assessment in a recent Financial Times column, "Yet investors are far from relaxed about the volatility spike [in early October], and understandably so. The recovery is less to do with convincing facts on the ground and more with repeated market conditioning during a pro-longed period of experimental central bank policy." El-Erian attributes low volatility, somewhat eerily, to "repeated market conditioning".
This is an important point. It is one thing that QE artificially lowered volatility and therefore distorted an important signal. By reducing dispersion, however, QE also affected the opportunity set for active money managers. Accordingly, many managers responded in ways that further exacerbated the distortion of volatility by completing a dangerous feedback loop.
Shilling describes the mechanism: "Hedge funds were originally formed to exploit arbitrage opportunities, but after exhausting those situations, they turned to directional bets on market movements using many styles in many different areas.” While hedge funds are extreme cases, in essence, they represent, ostensibly, what all actively managed funds seek to accomplish: superior performance. When the normal array of opportunities for these funds dries up, they either need to return money or find other ways to justify their management fees. The unfortunate reality is that many opt for the latter and start making directional bets. What happens, then, is that QE reduces volatility and dispersion, this reduces active management opportunities, active managers start making directional bets on the market, and these directional bets further reduce volatility. This cycle feeds on itself until something breaks.
This characterization of market behavior invites a number of important questions for those interested in getting to the bottom of the matter. An obvious immediate one is: Since little to no advantage exists for making directional bets, isn't this really just gambling? The answer to that is yes. While there is no easy answer for active managers trying to adapt to a landscape of artificially suppressed opportunity, making progressively larger bets for which one has no particular advantage and which are extremely unlikely to persist seriously challenges the tenets of fiduciary duty. Such reactions are most likely representative of increasingly desperate attempts by managers to stay in the game for as long as they can. It is useful to note, however, that not all managers have reacted this way. In stark contrast, a handful of elite hedge funds have actually returned money to investors and a small subset of long-only managers have raised allocations to cash while waiting for better opportunities.
Another important question is: If a large part of the market is making directional bets, doesn’t that significantly increase systemic risk and the chance of a big market decline? The answer to that is also yes. The more herding that goes on the less balance there is and balance creates stability. Corroborating this position, a fairly report in the Financial Analysts Journal, "How Index Trading Increases Market Vulnerability," shows that systemic market risk has increased with the proliferation of index funds and ETFs. This is extremely important to be aware of for two reasons. For one, it authoritatively refutes the widely reported volatility measures. Further, it indicates that market risk is actually greater now than it used to be and that fact should inform decisions regarding appropriate exposure to stocks.
Finally, investors might want to know who can help navigate the investment environment when the instruments aren’t working very well? Unfortunately the answer is not very encouraging. Since most managers know that they will lose business if they underperform for even a short period of time, their investment horizons have consistently dwindled down to a year or less in most cases. One consequence of this reality is that their vendors - analysts, research firms, etc. address the needs of “professional” money managers by focusing on time horizons of a year or less. As a result, a large bulk of the information, investment research, analysis, and commentary are all strongly biased to the short-term. This limited view of the world substantially understates risks that can realistically, and often even probably, unfold over a longer time horizon.
For many investors this state of affairs vastly complicates their task because the tacit assumption behind most investment research is a time horizon of a year or less. Since most most investors have very long time horizons of at least several years and in many cases decades, there is an enormous mismatch in time horizons between their investment objectives and the research and advice they receive.
This horizon mismatch is especially relevant in regards to exposure to stocks. Over extreme horizons of multiple decades it’s probably fair to assume that riskier assets like stocks will outperform. Over horizons of less than ten years, however, the performance of stocks can vary widely. The current reality of increasing systemic risk and extended valuations belies suppressed volatility measures and bodes poorly for expected returns over this horizon. Given such elevated potential for disappointment over this time horizon, it is especially important to ensure that the horizon assumption behind your research resembles that of your investment goals.
Unfortunately, there is good evidence this may not be happening. A recent survey by the Financial Times showed that 27% of investors over 60 years old are willing to put more than half of their portfolios into stocks. That such a large subset of investors with presumably shorter investment horizons are willing to accept such disproportionately large exposure to risky assets suggests that some investors may have already suffered from horizon mismatch.
In conclusion, things happen in the course of everyday life that can create a modest nuisance but that are ultimately quite manageable. This is why we have warning lights and alarms -- so as to prevent things from becoming so severely broken that they cause serious problems. The check engine light on your car, the fuel gauge, or even the timer for the turkey in the oven are all examples of early warning systems that help us manage situations well before they become big problems. Market volatility is also such a measure, but unfortunately that warning light is being "taped over". Most of us wouldn't consider going on a long car trip without working warnings lights or a fuel gauge. Investors should be at least as cautious when managing their life’s savings.
November 2014
A few years ago I took my car in to have some work done by the local car guy. When I picked it up, I noticed a warning light on the dash and asked about it. He said, in his matter-of-fact way, "No problem, I'll just put a piece of tape over it." Well this is the same guy who suggested I just turn the radio up when I asked about a squeaking sound the car was making. At any rate, after we stopped chuckling at the obvious joke, he told me what the problem was and took care of it.
If only it were so in today's capital markets. Unfortunately volatility, which typically serves as a useful warning light for market risks, has been "taped over". Certainly this makes it much more difficult for savvy investors to gauge market risks because it deprives them of a useful source of information and forces them to rely on other indicators that typically aren't as accurate. But at least they see the tape and know to look elsewhere for signals. Novice investors, however, are seriously challenged to even notice the tape and are therefore much more likely to misinterpret the situation. For them, the fact that there is no glowing warning light mistakenly sends an "all clear" signal to increase exposure to the market.
Market veteran Gary Shilling describes the situation as well as anyone in his November Insight letter: "The Fed’s bailout of Wall Street and its virtual promise to keep pumping out money through quantitative easing not only hyped stocks but collapsed risk and volatility. The broad spectrum stocks advanced pretty much in unison and stock market dispersion—the differences of individual stock performance compared to others—fell sharply, even below the pre-crisis level." In other words, an important consequence of the Fed's quantitative easing (QE) policy was to put tape over the volatility warning light.
Shilling is not alone in this assessment. Mohamed El-Erian, the well-respected former co-CEO of PIMCO and former head of the Harvard endowment offered his assessment in a recent Financial Times column, "Yet investors are far from relaxed about the volatility spike [in early October], and understandably so. The recovery is less to do with convincing facts on the ground and more with repeated market conditioning during a pro-longed period of experimental central bank policy." El-Erian attributes low volatility, somewhat eerily, to "repeated market conditioning".
This is an important point. It is one thing that QE artificially lowered volatility and therefore distorted an important signal. By reducing dispersion, however, QE also affected the opportunity set for active money managers. Accordingly, many managers responded in ways that further exacerbated the distortion of volatility by completing a dangerous feedback loop.
Shilling describes the mechanism: "Hedge funds were originally formed to exploit arbitrage opportunities, but after exhausting those situations, they turned to directional bets on market movements using many styles in many different areas.” While hedge funds are extreme cases, in essence, they represent, ostensibly, what all actively managed funds seek to accomplish: superior performance. When the normal array of opportunities for these funds dries up, they either need to return money or find other ways to justify their management fees. The unfortunate reality is that many opt for the latter and start making directional bets. What happens, then, is that QE reduces volatility and dispersion, this reduces active management opportunities, active managers start making directional bets on the market, and these directional bets further reduce volatility. This cycle feeds on itself until something breaks.
This characterization of market behavior invites a number of important questions for those interested in getting to the bottom of the matter. An obvious immediate one is: Since little to no advantage exists for making directional bets, isn't this really just gambling? The answer to that is yes. While there is no easy answer for active managers trying to adapt to a landscape of artificially suppressed opportunity, making progressively larger bets for which one has no particular advantage and which are extremely unlikely to persist seriously challenges the tenets of fiduciary duty. Such reactions are most likely representative of increasingly desperate attempts by managers to stay in the game for as long as they can. It is useful to note, however, that not all managers have reacted this way. In stark contrast, a handful of elite hedge funds have actually returned money to investors and a small subset of long-only managers have raised allocations to cash while waiting for better opportunities.
Another important question is: If a large part of the market is making directional bets, doesn’t that significantly increase systemic risk and the chance of a big market decline? The answer to that is also yes. The more herding that goes on the less balance there is and balance creates stability. Corroborating this position, a fairly report in the Financial Analysts Journal, "How Index Trading Increases Market Vulnerability," shows that systemic market risk has increased with the proliferation of index funds and ETFs. This is extremely important to be aware of for two reasons. For one, it authoritatively refutes the widely reported volatility measures. Further, it indicates that market risk is actually greater now than it used to be and that fact should inform decisions regarding appropriate exposure to stocks.
Finally, investors might want to know who can help navigate the investment environment when the instruments aren’t working very well? Unfortunately the answer is not very encouraging. Since most managers know that they will lose business if they underperform for even a short period of time, their investment horizons have consistently dwindled down to a year or less in most cases. One consequence of this reality is that their vendors - analysts, research firms, etc. address the needs of “professional” money managers by focusing on time horizons of a year or less. As a result, a large bulk of the information, investment research, analysis, and commentary are all strongly biased to the short-term. This limited view of the world substantially understates risks that can realistically, and often even probably, unfold over a longer time horizon.
For many investors this state of affairs vastly complicates their task because the tacit assumption behind most investment research is a time horizon of a year or less. Since most most investors have very long time horizons of at least several years and in many cases decades, there is an enormous mismatch in time horizons between their investment objectives and the research and advice they receive.
This horizon mismatch is especially relevant in regards to exposure to stocks. Over extreme horizons of multiple decades it’s probably fair to assume that riskier assets like stocks will outperform. Over horizons of less than ten years, however, the performance of stocks can vary widely. The current reality of increasing systemic risk and extended valuations belies suppressed volatility measures and bodes poorly for expected returns over this horizon. Given such elevated potential for disappointment over this time horizon, it is especially important to ensure that the horizon assumption behind your research resembles that of your investment goals.
Unfortunately, there is good evidence this may not be happening. A recent survey by the Financial Times showed that 27% of investors over 60 years old are willing to put more than half of their portfolios into stocks. That such a large subset of investors with presumably shorter investment horizons are willing to accept such disproportionately large exposure to risky assets suggests that some investors may have already suffered from horizon mismatch.
In conclusion, things happen in the course of everyday life that can create a modest nuisance but that are ultimately quite manageable. This is why we have warning lights and alarms -- so as to prevent things from becoming so severely broken that they cause serious problems. The check engine light on your car, the fuel gauge, or even the timer for the turkey in the oven are all examples of early warning systems that help us manage situations well before they become big problems. Market volatility is also such a measure, but unfortunately that warning light is being "taped over". Most of us wouldn't consider going on a long car trip without working warnings lights or a fuel gauge. Investors should be at least as cautious when managing their life’s savings.
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